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Present State of the Islamisation of the Financial System in Pakistan

Pakistan embarked on a process of the Islamisation of its financial system in 1979. Though the financial system of the country has undergone significant changes since then, the process of Islamisation is yet to run its full course. The mea sures adopted for the Islamisation of the financial system have also been characterised by a number of qualitative deficiencies. The deficiencies and shortcomings of the steps taken for the Islamisation of the financial system have been widely discussed in the country in recent years. The stage for a basic reformation of the financial system in the light of Islamic teachings has been set by the judgement delivered by the Federal Shari'ah Court in November 1991 which has declared a number of existing financial laws and practices as repugnant to the injunctions of Islam and called upon the government and other concerned agencies to take necessary action to bring them in conformity with the Islamic tenets by the end of June 1992.

This paper reviews the efforts made so far for the Islamisation of the financial system in Pakistan. The paper is divided into three sections. The first section provides the historical perspective of the Islamisation efforts. The second section describes the steps taken for the Islamisation of the financial system. The third and the final section contains an appraisal of the present state of the Islamisation of the financial system in Pakistan.

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CII Report and Strategy

In September 1977, the President asked the Council of Islamic Ideology (CII) to prepare a blueprint of an interest- free economic system in the light of Islamic teachings. To assist it in this task, CII set up a panel of economists and bankers consisting of 15 highly-qualified economists, experienced central and commercial bankers and financial experts. In view of the complexity of the task of eliminating interest from a system in which it was deeply embedded, the panel advocated a gradual approach. It first submitted an interim report which recommended immediate removal of interest from those financial institutions whose transactions were relatively less complex and from where interest could be removed with greatest ease. This was followed by its final report which contained recommendations for eliminating interest from all domestic financial transactions. The panel recognised the difficulty in eliminating interest from foreign transactions all of a sudden and advised reduction in dependence on interest-bearing foreign loans. The CII scrutinised the contents of both these reports, and after making certain changes to ensure complete conformity with Islamic injunctions, incorporated them in its interim and final reports submitted to the government in November 1978 and June 1980, respectively.

The report of the Council of Islamic Ideology (hereinafter referred to as CII report) contained a detailed blueprint for reorganisation of banking practices and procedures on the basis of the principles of profit-loss sharing in consonance with the Islamic legal concepts of mudarba and musharakah. The CII report emphasised that the ideal Islamic techniques to replace interest in the banking and financial fields are profit-loss sharing and qard-e-hasan. However, it gave due recognition to difficulties that may arise in changing the whole system to profit-loss sharing in one step and also the fact that there are certain spheres where it may not be possible to use the system of profit-loss sharing. It, therefore, gave qualified approval to certain other methods being used in conjunction with profit-loss sharing like leasing, hire-pur chase, bai' mu‘ajjal, investment auctioning and financing on the basis of normal rate of return. However, cautioning against the danger that such methods could open a back door for interest, it emphasised that their use should be kept to the minimum that may be unavoidably necessary and that their use as general techniques of financing must never be allowed.

The C1I report stressed that lack of proper maintenance of accounts due to large-scale illiteracy and the tendency to conceal true profits on the part of business concerns would act as a hindrance in widespread adoption of the system of profit-loss sharing by the banks. It advocated elimination of illiteracy, moral reformation, a thorough reform of the tax system and improvement in the systems of accounting and auditing to create a favourable environment for the success of profit- loss sharing system.

No change was contemplated in the CII report in the functions and responsibilities of the central bank. However, it recognised that the operating procedures and the contents and substance of its monetary policy instruments would undergo significant changes consequent to the elimination of interest. These were discussed in detail in CII report.

In view of the complexity of the task, the CII report suggested that elimination of interest may be made gradually under a phased programme. It also laid down a plan of action with an order of priority for elimination of interest from different sectors. It recommended elimination of interest from government transactions in the first phase, followed by elimination of interest from the assets side of the operations of the commercial banks and other financial institutions, culminating finally in deposits of the banks becoming interest- free in the true sense of the term. The report argued strongly against starting the experimentation with model banks or opening interest-free counters in existing commercial banks, side by side with interest-based operations.

The CII report set the stage for the phased elimination of interest from banking and financial transactions. In the meantime, a report on the elimination of interest had also been prepared by a committee headed by the governor, State Bank of Pakistan. The report prepared by this committee did not differ substantially from the CII report in as far as the measures to eliminate interest were concerned. However, the CII report was a more comprehensive document and its special importance lay in the fact that it was prepared by a constitutional body which is specially charged with advising government on matters related to Shari’ah.

Simultaneously, the State Bank undertook the formidable task of overhauling the then existing banking legislation to meet the requirements of an interest-free system. The State Bank of Pakistan Act and Banking Companies Ordinance underwent substantive and far-reaching changes. Amendments were made in a number of other laws having a bearing on banking transactions. Subsequently, as the new system got under way, further appropriate legislation was undertaken.

Phased Elimination (1979-1985)

The actual process of phased elimination of interest from domestic banking and financial transactions was set in motion with the historic announcement by the then president on February 10, 1979, on the occasion of the birthday of the Prophet (pbuh) that government planned to remove interest from the economy within a period of three years and that a decision had been taken to make a beginning in this direction with the elimination of interest from the operations of the House Building Finance Corporation, National Investment Trust and mutual funds of the Investment Corporation of Pakistan. Within a few months of this announcement, these specialised financial institutions took the necessary steps to re-orientate their activities on a non-interest basis.

The conversion of operations of commercial banks to noninterest basis was a much more complex task and had therefore to be spread over a longer time period. Effective from July 1, 1979, the government introduced a scheme under which the nationalised commercial banks were required to provide interest-free loans to small farmers for meeting their lier ones. But of course, it was not a complete catalogue; the real list is a formidable one.

During the last few years, a wrong tendency has developed. Contrary to previous years, when they were not saying they will charge a mark-up on loans, because anything on loan over and above the principal amount is interest. However, it is now being said that a 13 to 14 percent mark-up will be provided on loans. This is the height of our deviation from Islamic path that being a Muslim nation we are using the word mark-up for interest. It is not a sale-and-purchase transaction. The genesis of mark-up lies in bai' mu'ajjal. In this case, there is no bai' and still it is being said that mark-up will be charged on loans.

Dr Zaman asked if we can Islamise the financial system without budgetary reforms. Prof Khurshid was very explicit on this, and I fully agree with him. The Council of Islamic Ideology, for very basic reasons, had recommended that in the first phase the elimination of interest from the government transactions should be undertaken. If the government has a high rate of interest structure to attract funds from the public, it should invite the private sector. It is only through this way that the private sector and banks can compete with the government schemes. They can always pitch the mark-up rate to the government rates, while in the case of profit-loss system since it depends upon the actual turnover of a business, they will be more hesitant. Several other reasons can be cited as well. I feel that unless there is a budgetary reform, it will be very difficult to Islamise the financial system.

Another participant observed that he was not in favour of banks engaged in mudarba. If you analyse the performance of various parties who have been provided loans by the banks, you will inevitably come to the conclusion that these are the smaller parties which have not defaulted, while the bigger parties have gone in default. Also, take the example of Grameen Bank of Bangladesh; it has been providing funds to persons who were almost penniless. Its performance is very good and repayment record is highly encouraging. I do not agree that if you extend mudarba funds to the unemployed, you will have bad loans. In fact, such people would be very much interested to keep themselves in good books with banks because they can expand their business by getting further mu- darba funds.

An International Islamic University working group, which included chartered accountants, bankers and economists, came out with strong allegations against the bankers. The group members were also against the income tax system which they said was making them dishonest. They say: ask any businessman whether he can afford to be in business if he remains honest. This indeed is a very bad situation. In fact, the Taxation Inquiry Commission headed by Dr Qamarul Islam has documented how bad the income tax system is. It seems that we all are to be blamed. I do not want to use the word failure, but we have tried the system half-heartedly and inefficiently.

Dr Hussein Mullick made a stringent attack on bureaucrats. We should not single out a particular group. I think we may extend our blame to the banks and the people in the central bank. Even the general public has shown apathy towards Islamic source of financing. But I agree with the State Bank that greater autonomy should be given to it in such matters.

Mr Abdul Jabbar Khan has very rightly pointed out that the Federal Shari‘ah Court has criticised both the mark-up system and the buy-back arrangement. He also made a very valuable point that we cannot afford to give up the mark-up system completely; that we have to distinguish between the mark-up system based on the concept of bai' mu'ajjal which according to the fatwa, is a permissible mode of financing used by Islamic banks all over the world including the Islamic Development Bank. Bai' mu‘ajjal and mark-up have to remain one component of the system because there are certain spheres where one cannot apply musharakah. For example, people who are illiterate, like farmers who do not maintain accounts, one cannot have musharakah with them. I think one has to have a whole range of modes of financing. We should try to give increasing prominence to musharakah and mudarba as time goes on. At the same time, we should continue with leasing, hire-purchase and mark-up in consonance with the Islamic teachings.

Finally, is the legal framework adequate for the success of the profit-loss system? I could not agree more with what has already been said. One of the IMF documents on Islamic banking says that the legal framework is not adequate. I think you have to overhaul the companies act, change banking laws and alter the profit-loss system.